Stress Testing

Muhammad Saifullah Bin Mohamed Azmi (1100314)

TK5413 ISLAMIC RISK MANAGEMENT

Content

1. Introduction to Stress Testing2. Stress Test & Bank Regulation3. Roles of Stress Testing4. Scenario & Sensitivity Analyses5. Stress Testing in Islamic Financial Institutions‘.6. Conducting Stress Test7. Limitation of Stress Test8. References

Stress Testing

Definition“A range of techniques used to access the vulnerability of portfolio to major changes in the macroenomic environment or to exceptional but plausible event.”

The objective of stress test is to make risk more transparent by estimating the potential losses on a portfolio in abnormal market.

It is often used to complement the internal model and management systems used by the financial institution for capital allocation decision.

Stress Test & Bank RegulationsStress testing techniques began to be applied widely by internationally active bank in the early 1990’s and now most of large financial institutions.

Banking supervisors and regulators have sanctioned the use of stress test as an important component of internal-model approach to market-risk monitoring.

The Basel Committee on Banking Supervision (BCBS) highlighted the need of stress testing in they published the “Amendment to the Capital Accord Incorporate Market Risk” in January 1996.

National bank supervisor and regulators (including Bank Negara) have issued their own guideline on stress testing in accordance with the principle laid down by BCBS.

According to Bank Negara guideline for Stress Testing (see page 5), it also applicable for Islamic banks, Takaful and Retakaful operator.

Role of Stress Test Standard Risk Management tool for licensed institutions

to understand the nature of their risk profile.

Help to identify the possible future unfavorable event that would affect on institution.

Help to identify exceptional but plausible event that can affect the institution if it really happened in the future.

To complement statistical model such as VaR by providing the assess the effect of tail event beyond the level of confidence assumed in the statistical model.

To be used in portfolio that lack of historical data which basically hard to build a statistical model due to insufficient data.

Categories of Stress Test

Stress Test

Scenario Analysis

Sensitivity Analysis

Scenario Analysis

Scenario Analysis

The historical scenario involves the reconstruction of historical events and

involves less judgment as it reflects actual stress market condition.

Hypothetical scenario means simulating shocks to events that have not yet happened or have no historical

precedent.

Example of Scenarios

Common Stress Test Scenarios

Category Historical Hypothetical

Equities Asian financial crisis 1997 Terrorist attacks 2001

Hypothetical stock market crashesTerrorist attack

Interest Rate Products Asian financial crisis 1997

Terrorist attacks 2001Historical interest rate

increase and decrease

US tighteningIncrease in inflation expectations.

Japanese monetary outlook

Commodities When price of oil per barrel hiked, the price of raw rubber also increased.

Commodity crisisMiddle east unrestOil Shortage

Sensitivity Analysis

Study on how the variation (uncertainty) in the output of a statistical model can be attributed to different variations in the inputs of the model. 

Technique for systematically changing variables in a model to determine the effects of such changes.

Sensitivity Analysis

Scenario & Sensitivity Analysis

It is somewhat unavoidable to distinguish between Scenario based analysis and sensitivity

test

In the sense that some scenario based analysis implicitly assume some scenario for sensitivity correlation estimators.

Conducting Stress Test

Type of Shock

Individual marketvariables

Underlyingvolatilities

Underlying correlation

Type of Scenario

Type of Risk Model

Market Risk Credit Risk Other

Type of Stress Test

Sensitivity Scenario Other

Historical Hypothetical Monte Carlo Simulation

Stress Test in Islamic Financial Institutions

Islamic Financial Institutions' exposed to market risk through 4 type of risk namely:-

1. Rate of return risk

2. Commodity Price Risk (Murabaha, Istisna’, Salam)

3. FX rate risk

4. Equity price risk (Musharakah, Murabahah)

Commodity Price Risk (Murabaha, Istisna’, Salam)

The behavior of commodities in Islamic Finance are driven both by direct & indirect by many different risk factor.

Price RiskCost Risk

Market Influence RiskFX Rate RiskQuantity Risk

Future Delivery RiskInverse Price Risk

Risk Exposed

Equity Price Risk(Musharakah, Mudaraba)

This type of risk can arise from the contract due to “profit & loss” sharing that is driven by the share in the investment equity.

Can result in equity price risk

Therefore:-

The more the complex the contract, the more risk exposure.

Because even simple portfolio carry more than one market risk factor.

Limitation of Stress Testing

1. It is based on projected scenarios and not real event, thus it is hard to choose the “right” event to be tested.

2. The cost incurred maybe expensive.

3. Wrong input will lead to wrong output. Thus wrong interpretation.

4. Only calculate “what would happen if” scenarios not the probability that such event would happen.

5. Limited to only portfolio which closely related to the market risk.

References

1. Guideline for Stress Testing, Bank Negara Malaysia.

2. Stress Testing; Challenge yourself before being Challenged, Ernst & Young (2009).

3. Stress Testing of Financial Systems; An Overview of Issues, Methodologies' & FSAP Experiences, IMF Working Paper (2001)

The End